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Introduction and Market Microstructure Data

Introduction and Market Microstructure Data. Prof. Ingrid M. Werner Spring 2004. What is market microstructure?.

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Introduction and Market Microstructure Data

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  1. Introduction and Market Microstructure Data Prof. Ingrid M. Werner Spring 2004

  2. What is market microstructure? • Traditional asset pricing aims to understand what should be the price of a security. It does not, however, address how prices adjust to reflect news nor does it explain how investors’ subjective assessment of a security “get into” the price. • In practice, news and investors’ valuations are incorporated into security prices through trading. • This means that the specific trading rules, and the strategies traders develop in response to these rules, will affect how asset prices change over time in response to new information.

  3. What is Market Microstructure? • Maureen O’Hara:“Market microstructure is the study of the process and outcomes of exchanging assets under explicit trading rules.” • It is one of the most rapidly growing areas in Finance. • It has a profound impact on the real world – on traders, broker/dealers, exchanges, regulators, and policy makers alike.

  4. Vignette WFA Sunriver, OR, 1996 • Distinguished speaker Prof. Joseph Williams UBC“The problem with Finance is that we have lost touch with the business world and the needs of those who are supposed to apply our theories.” • Comment by Prof. Maureen O’Hara, Cornell“He obviously does not follow the field of market microstructure…” • Market microstructure is probably the area in Finance with the closest ties to practice. • Conferences draw a steady crowd of practitioners, regulators, lawyers, and computer scientist who pay “exorbitant” conference fees to hear academics present thei research findings!!!

  5. Cheerleaders • Market centers have made transactions data available to researchers • Equities: • NYSE, Nasdaq, Regionals, Island (INET) • Paris Bourse, London Stock Exchange, Toronto Stock Exchange, Tokyo Stock Exchange, Hong Kong Stock Exchange, Korea Stock Exchange, … • Derivatives: • CBOE, ISE, CME, etc. • Bonds: • GovPX • Exchange Rates: • Ohlsen Associates, Reuters

  6. Cheerleaders • Market centers have also provided generous research support. • NYSE Visiting Academic Fellow • Paul Bennett • NYSE Day on the Floor Program • Nasdaq Visiting Research Economists • Frank Hatheway and Tim McCormick • Tailored datasets • Proprietary data • Commissioned studies • Conferences…

  7. Regulators actually listen! • Believe it or not, this is a field where the regulators actually listen to the advise of academics! • Manning Rules (1994, 1995) • Concept Release (1999, Richard Lindsey) • Regulation ATS (1999) • Decimalization (2000-2001, Larry Harris) • Rule 11Ac1-5, Rule 11Ac1-6 (2001, Mark Ready) • Regulation NMS (2004, Larry Harris) • Public Comment • Round table discussions

  8. Why do they care? • Data guided by theory, Theory guided by data • Efficiency – welfare issues • Is insider trading bad? • Market design issues • Agency auction market • Dealer market • Electronic limit order books • Market performance issues • Transaction costs • Shock absorption/resiliency • Trading halts • Competition for order flow • Industrial organization

  9. What is in it for me? • Given the amount of research in the area, it still surprises me how limited our knowledge is of different market structures. • This is good news!!! • There is plenty of room for more research!!! • This course will cover only the basics. • I will try to point you in the direction of fruitful areas for research as we go along.

  10. Who am I? • Instructor: Prof. Ingrid M. Werner • At OSU since 1998 • Prior to that, at Stanford Business School (1990-1998) • PhD economics from University of Rochester (1990) and MBA from Stockholm School of Economics (1984) • Visited NYSE 1997 • Visited Nasdaq 2001-2002

  11. Course Topics • Introduction and market microstructure data. • Market making and inventory control • Asymmetric information and strategic trading • Block trades and institutional trading costs • Limit order books and order submission strategies • Estimating structural microstructure models (PIN), modeling irregularly spaced data (ACD), linking microstructure to asset pricing, event studies, etc.

  12. Empirical Projects • Project I • Inventory control • Data from the London Stock Exchange • Project II • Intraday patterns and trading costs • Data from the NYSE and Nasdaq (TAQ) • Project III • Order submission strategies • Data from the Paris Bourse

  13. Major trading issues • Liquidity • Transaction Costs • Informative Prices • Volatility • Trading Profits

  14. Forces affecting the structure of markets • Demand for trading • Liquidity trading • Information trading • Noise trading (Black (1991)) • Order processing costs • Information system • Order routing systems (e.g., SuperDOT) • Order execution system (e.g., SuperMontage) • Clearing and Settlement

  15. Forces affecting the structure of markets • Technology and automated trading • Resistance/vested interests (e.g., NYSE floor community!) • Block traders • Risk bearing • Inventory risk • Payments risk • Institutionalization • 50% of volume is institutional traders

  16. Forces affecting the structure of markets • Free trading options • Stale limit orders • Stale quotes • Information trading • Liquidity traders lose • Informed traders need to be compensated for research • Anonymity, Reputation, Transparency • Disclosure of trades and quotes • Delayed disclosure • Upstairs facilitated trade • Reputation through repeated trading

  17. Players

  18. Two sides of the trading industry • People and institutions who use market services are on the buy-side. • Those who provide market services are on the sell-side. • These sides have nothing to do with whether you are a buyer or seller of a specific security.

  19. Buy-side players - Investors • Individuals • Corporate pension fund sponsors • Charitable trusts • Legal trusts • Endowments=> Stocks and Bonds • Investment managers • Corporate investment funds • Insurance reserve funds • Governmental funds

  20. Homeoweners Students Corporations=> Mortgages, Bonds, Notes Farmers Manufacturers Miners Shippers Financial Institutions => Forwards, Futures, Swaps, and Options Buy-side players – Borrowers and Hedgers

  21. Sell-side players • Dealers trade for their own accounts. • Day Traders • Scalpers • “Locals” • Brokers trade for other people’s accounts. • Retail and institutional • Full-service and discount • Broker-dealers do both. • Specialists • Wire houses

  22. Sell-side trade facilitators • Exchanges provide systems that help traders arrange their trades. • Note that exchanges and brokers often compete with each other. • Clearing firms clear and settle trades • E.g., Bear Sterns. • Clearing houses help settle trades and guarantee that traders will perform. • Depositories and custodians hold securities.

  23. A typical set of relationships • A sponsor owns funds. • An investment manager makes portfolio decisions. • A broker implements trade decisions. • A dealer supplies liquidity. • A clearing house guarantees the trade. • A depository holds the security. • Consultants advise everyone.

  24. The Market Centers

  25. US primary listing market • New York Stock Exchange (N) • American Stock Exchange (A) • Nasdaq (Q) • Over-the-Counter (OTC) • Nasdaq small cap (S) • OTCBB (U) • Pink Sheets

  26. US regional exchanges • Pacific Exchange / Archipelago (P) • Chicago (formerly Midwestern) Stock Exchange (M) • Boston Stock Exchange (B) • Philadelphia Stock Exchange (X) • Cincinnati Stock Exchange (C)

  27. Third markets • OTC Dealers (Madoff, Knight/Trimark) (T) • Jefferies, Jones & Co, Cantor Fitzgerald • ECN’s (Proprietary trading systems) • Instinet • Island • Archipelago • Posit • The Crossing Network • Bloomberg B-Trade • Liquidnet • Harborside

  28. The market for Nasdaq stocks today SEC public investors broker-dealers Instinet ARCA NASD broker dealers 10 ECNs Island non U.S. markets Posit NASDAQ SuperMontage Crossing Network Merging Liquidnet Amex PHLX CHX CSE direct access U.S. markets Source: Goldman Sachs, Trading & Market Structure Analysis

  29. Volume distribution – Nasdaq stocks • Share volume • Single-counted • Internal matches only • All hours • Excluding ETFs October 2003 • Mostly broker-dealer upstairs trades • But also small activity on: • Brut (also in SM) • NexTrade (also in SM) • MarketXT (also in SM) • Attain (also in SM) • TradeBook (also in SM) • Other ATSs 2 to 5 percent? Source: Goldman Sachs, Trading & Market Structure Analysis

  30. The market for NYSE stocks today SEC public investors broker-dealers Knight Madoff Instinet NASD broker dealers 10 ECNs non U.S. markets Posit Crossing Network ARC U.S. markets CHX NYSE Liquidnet PHLX ITS direct access CSE HarborSide Millennium BSE Source: Goldman Sachs, Trading & Market Structure Analysis

  31. Volume distribution - NYSE stocks October 2003 • Single-counted, share volume • Internal matches only • All hours • Excluding ETFs Seeing through Nasdaq InterMarket Source: Goldman Sachs Trading & Market Structure Analysis

  32. Major international stock markets • Europe; • London Stock Exchange (LSE) • EuroNext (Paris/Netherlands/Belgium) • Deutsche Borse (DB) • Milan Stock Exchange • Swiss Stock Exchange (also Virt-X) • Stockholm/Copenhagen/Helsinki/Oslo (OM) • Asia: • Tokyo Stock Exchange (TSE) • Taiwan Stock Exchange • Korean Stock Exchange • Australian Stock Exchange (ASX) • Hong Kong Stock Exchange • Toronto Stock Exchange (TSX)

  33. US bond markets • Corporate and government bonds trade OTC in wire houses. • Inter-dealer brokers often organize markets. • E.g., Cantor Fitzgerald (eSpeed) • NYSE- and AMEX-listed corporate bond markets are very small.

  34. US Equity options CBOE Amex P-Coast Philly ISE BOX US Futures CME CBOT NYMEX NYBOT KCBOT MGE … US Derivatives markets

  35. The regulators • Securities and Exchange Commission (SEC) • Securities markets, equity options markets, and cash-settled equity index options markets • Commodity Futures Trading Commission (CFTC) • Commodity spot, forward, and futures markets • The SEC and the CFTC write regulations to interpret and implement the laws that fall into their jurisdiction • They also collect and disseminate information • Additional regulators include: the Federal Reserve Board (Reg. T margins), state-specific SECs, SROs, FASB, AIMR, IOSCO, WFE, and ICSA…

  36. A Primer on Orders

  37. What are orders? • Orders are instructions that traders give to the brokers and exchanges which arrange their trades. • Instrument (or instruments) to trade. • How much to trade. • Whether to buy or sell. • Conditions • Limit price • Duration • Partial or fill-or-kill • Where to present the order • How to search for other side • Desired counterparts…

  38. Who uses orders? • Traders that either do not have direct access to the markets, or do not have the time to monitor the markets use orders. • Have to anticipate what is going to happen. • Have to clearly delineate contingencies. • At a disadvantage vis-à-vis professional traders. • Risk of misunderstandings • Conflicts of interest • Speed of reaction to changing market conditions • Cancellations can be time consuming • Access to order flow information

  39. What are bids and offers (asks)? • Dealers have an obligation to continuously quote bids and offers, and the associated sizes (number of shares), when they are registered market markers for the stock. • Their quotes also have to be firm during regular market hours. • Public orders with a price limit can also become the market bid or offer if they are at a better price than those currently quoted by a registered market maker. • The market’s best bid and offer constitute the inside market, the best bid/ask, or the BBO. The best bid and offer across all markets trading an instrument is called the NBBO. • The difference between the best offer and the best bid is the bid/ask spread, or the inside spread (touch, fourchette, vigorish…) • Orders supply liquidity if they give other traders the opportunity to trade. • Orders demand liquidity (immediacy) if they take advantage of the liquidity supplied by other traders’ orders.

  40. What are agency/proprietary orders? • Orders submitted by traders for their own account are proprietary orders. • Broker-dealers and dealers. • Since most traders are unable to directly access the markets, most order are instead agency orders. • Presented by a broker to the market. • Agency orders can be held or not held/worked. • Held orders are those when the broker has an obligation to a client to fill the order. • Market-not-held orders are institutional orders where the trader hires a broker-dealer to execute the order. • Working an orders means that a broker-dealer takes some time to fill the order.

  41. Market orders • A market order is an instruction to trade at the best price currently available in the market. • Immediacy • Buy at ask/sell at bid => pay the bid/ask spread • Price uncertainty • Suppose the quotes for ABCD are a bid of $50.00 and an offer of $50.50, what is the transactions costs for a trader using a market buy order in ABCD? • Why? • What is the best estimate of the value of ABCD?

  42. Price improvement • Price improvement is when a trader is willing to step up and offer a better price than that of the prevailing quotes (at order arrival). • Who benefits from price improvement? • Who looses from price improvement? • Should it be allowed to offer price improvement? • Should everyone be allowed to offer price improvement? • Does your answer depend on the minimum price increment in the market?

  43. Market impact • Large market orders tend to move prices. • Liquidity might not be sufficient at the inside quotes for large orders to fill at the best price. • For example, suppose that a 10K share market buy order arrives in IBM and the best offer is $100 for 5K shares. • Half the order will fill at $100, but the next 5K will have to fill at the next price in the book, say at $100.02 (where we assume that there is also 5K offered). • The volume-weighted average price for the order will be $100.01, which is larger than $100.00. • Prices might move further following the trade. • Information and liquidity reasons.

  44. Limit orders • A limit order is an instruction to trade at the best price available, but only if it is no worse than the limit price specified by the trader. • OK to trade at or above the limit sell price. • OK to trade at or below limit buy price. • If the limit order is executable (marketable), than the broker (or an exchange) will fill the order right away. • If the order is not executable, the order will be a standing offer to trade. • Waiting for incoming order to obtain a fill. • Cancel the order. • Standing orders are placed in a file called a limit order book.

  45. Limit order placement

  46. Limit orders are trading options • Limit orders offer other traders an option to trade, that is they supply liquidity. • Sell limit orders are call options that give traders the right to buy. • Buy limit orders are put options that give traders the right to sell. • What is the option strike price? • How are limit orders different from regular option contracts? • On what factors does the value of the option to trade depend? • How do these factors impact the bid ask spread?

  47. Why would anyone use limit orders? • The compensation that limit order traders hope to receive for giving away free trading options is to trade at a better price. • However, options might not fill (execution uncertainty). • Chasing the price. • Limit order traders might also regret having had their order filled (adverse selection)… • What could cause a limit order to regret obtaining a fill? • How would this fact affect strategies involving limit orders?

  48. Other order types • A stop instruction stops an order from executing until price reaches a stop price specified by a trader. • Buy only after price rises to the stop price. • Sell only after price falls to the stop price. • Can be either stop market or stop limit orders. • How are stop limit orders different from regular limit orders? • How do stop orders affect liquidity? • Market-if-touched orders become a market order when price reaches some preset touch price. • Buy when market falls to the touch price. • Sell when market rises to the touch price. • How are MIT orders different from regular limit orders? • Do MIT orders demand or supply liquidity?

  49. Tick-sensitive orders • Traders who want to condition their orders on the last price change submit tick-sensitive orders. • Uptick = current price is above the last price • Downtick = current price is below the last price • Zero-tick = current price is the same as last price • Do tick-sensitive orders demand or supply liquidity? • How do tick-sensitive orders compare to limit orders? • How are tick-sensitive orders affected by the minimum price-increment?

  50. Day orders (DAY) Good-til-cancel (GTC) orders Good until orders Good-this-week (GTW) orders, good-this-month (GTM) orders Immediate-or-cancel (IOC) orders Fill-or-kill (FOK) orders, good-on-sight orders Good-after-orders Market-on-open (MOO) orders Market-on-close (MOC) orders All-or-none (AON) orders Minimum-or-none (MON) orders All-or-nothing, and minimum acceptable quantity instructions Spread orders Display instructions Hidden/Ice-berg orders/reserve Substitution orders Special settlement instructions Regular-way settlement Cash settlement How do these affect the cost of trading? Additional order instructions

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